How to Evaluate Investment Performance

In this blog, I provide some ideas on how to evaluate investment performance from a variety of angles. As you read this article, I encourage you to keep in mind that there are both art and science to the issue.

Index-Based Benchmarking

Measuring investment performance against well-known indices is the most common form of investment performance evaluation for a portfolio. In fact, the terms “index” and “benchmark” are used interchangeably by some.

An important nuance to this approach is that a single index is unlikely to be an adequate benchmark for a diversified portfolio. Instead, investment portfolio performance should typically be measured against a blend of indices. The weights of each index in the blend should align with the portfolio’s components—either at the broad asset class level (e.g. equity vs. fixed income) or at the more detailed sub-asset class level.

Selecting which indices to use is also important. For asset class-based benchmarks, using broad-based indices often makes sense. For sub-asset class benchmarks, the use of best-fit indices for each manager/fund may be more suitable.

Peer Group Analysis

Peer group analysis is a form of investment performance evaluation that uses real portfolios. In practice, it is difficult to perform peer group analysis at the portfolio level due to issues around the availability, standardization, and quality control of data. But if proper comparative data is available, peer group analysis allows organizations to determine how their investment portfolio performance stacks up against that of similar institutions.

On the other hand, peer group analysis is much easier to perform for individual sub-asset classes. Asset managers must conform to reporting standards. Most asset managers also report their results to a number of databases, facilitating an adequate group against which to compare.

Goals-Based Evaluation

A third approach of how to evaluate investment performance is internally, rather than externally, focused. Goals-based evaluation builds performance targets around the organization’s wants or needs. For example, consider an endowment that spends a percentage of its market value. The organization may wish to conduct its investment performance evaluation against a goal of the endowment’s spending rate plus inflation.

A goals-based approach is a meaningful way to measure investment portfolio performance. However, it is also necessary to understand investment returns in the context of what is happening within investment markets. In any particular period, a “spending rate plus inflation” goal may be either too easy or too high a bar to achieve. Goals-based evaluation is best complemented by one or both of the prior two methods.

Cost Analysis

While not a direct performance item, we believe it is important for organizations to also understand the cost of their investment programs. In fact, cost is a component of investment returns. The larger issue with investment program cost is similar to that with the cost of any product or service: is the organization paying a fair price in the context of the market?

Different investment advisory and consulting firms offer different services and price these services differently. Unfortunately, “real life” cost information is more difficult to obtain for these types of firms as many arrangements are individually negotiated and not often published in aggregate form.

Information on investment product costs is available through the same databases that provide performance information. Additionally, asset managers often publish their costs. The key for an organization is accessing an investment strategy through a cost-efficient investment vehicle, given that the same strategy is often offered through multiple options such as share classes.

Final Thoughts

Investment portfolio performance can take many shapes, and no single approach is perfect. We encourage organizations to determine what is most important within their programs and then shape their investment performance evaluation methodologies accordingly. Additionally, we suggest that organizations not react too hastily or too drastically to perceived underperformance. Essentially all investment strategies will have their relative ups and downs. More important than short-term performance is whether the investment program is operating accordingly to a well-structured investment policy.

This article adaptation is from our partner, Cornerstone Management. Cornerstone Management has proudly provided independent financial planning services to Christian nonprofit organizations for over 30 years.